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Falling oil prices and their impact on growth and financial vulnerability

Since mid-2013, the price of a barrel of oil has fallen $40, from $100 to below $60. The drop stems from the economic slowdown in major countries such as China, Brazil and Russia, but that is by no means the whole story.

Excess production capacity resulting from years of (over) investment in exploration, development and production, the emergence of shale oil in the United States and oil market manoeuvring by OPEC, specifically Saudi Arabia, are the major factors behind this slide. Beyond the further decline in inflation rates and inflation expectations (an additional problem for countries that are fighting deflation), falling oil prices are good for all consumer nations, with China foremost.. and it provides a shot in the arm to countries fighting inflation (India, Indonesia). Conversely, falling oil prices are further weakening countries that are highly dependent on it (exports, tax revenues). Meanwhile, the economic slowdown in Russia is turning into a severe recession. As far as investors are concerned, the current environment is a reason for preferring resource-consuming countries to resource-producing countries. For the latter, this assumption also takes into account the usual solvency and economic vulnerability criteria. Canada, Norway and Kazakhstan now appear to be much less risky than Russia, Venezuela, Angola, Bahrain, Ecuador or Nigeria.

The price of oil has been declining steadily for a little more than a year. The price of Brent crude is now below $60 a barrel. What’s behind this 50% slide since last June?

We can identify several factors:

First, lower crude prices are due to the sharp slowdown in the world's major consuming countries, led by China. This is a typical demand-side shock. However, this argument alone does not sufficiently explain falling oil prices. It is a known fact that global growth is slowing but it remains resilient. Growth in the United States is still solid and in Europe it has stabilised. All in all, because of the economic slowdown in the major emerging countries, global growth (along the lines of 3.5%, as in 2013) is expected to be 3.2% in 2015. In short, it is clear that growth, which undoubtedly had an influence on the price of oil as momentum slowed, does not explain everything. The proof of this is that other commodities (ferrous and nonferrous metals) declined much less over the same period (see chart n°1).

The development of shale oil by the United States has further destabilised the energy market. US oil production rose by more than 65% in the space of five years and it is now one of the largest oil producers, if not the largest. It would be no exaggeration to say that shale development has changed the geopolitics of oil. We should also add that the United States, already an exporter of refined oil, could easily become an exporter of crude, an activity that has been banned for more than 40 years. The likelihood that the next Senate may lift the ban is driving prices lower.

Saudi Arabia's specific approach has also pushed prices down. Accustomed to playing the role of swing producer against all price movements, the country recently shifted its strategy for geopolitical reasons. It previously adopted the same strategy, in 1986, which led to a similar 50% decline in the price of crude. Keeping the price of oil at an extremely low level is one way to greatly hinder some countries, be they traditional enemies or partners:

It should be reiterated that shale oil extraction in the United States has break-evens ranging from $40 to $180 a barrel. At $60 a barrel, most development projects are no longer profitable. It would appear that Saudi Arabia has taken a dim view of the development of these competing technologies, and its determination to keep oil prices low is one of the consequences. It should also be noted that Saudi Arabia very recently granted a $2 per barrel discount on sales of oil to the United States and Asia.

Russia, which supports Syria, heavily depends on its oil exports and its ability to balance its budget is tied to changing prices for a barrel of oil.

Iran, another country that cannot be counted as one of Saudi Arabia's allies, is also suffering because of cheap oil.

Lastly, Saudi Arabia views its OPEC partners as lacking the unanimity needed to control oil prices. There's no doubt that the current situation demonstrates to them just how necessary close collaboration with Saudi Arabia is.

All things considered, Saudi Arabia is showing that it is capable of controlling the price of oil, a vital commodity for many countries, as well as the profitability of extraction activities and the attainment of fiscal balance.

Finally, lower oil prices are tied to excess production capacity resulting from periods of high prices, all of which were marked by massive investment: American shale oil and the Canadian tar sands are the most obvious examples. In fact, annual investment in exploration, development and production has increased sevenfold between the 1990s and today. All these periods of heavy investment invariably led to phases with lower prices. We are going through one of those phases now.

It's obvious that some of the factors mentioned above are demand-side shocks while others are supply-side shocks. Identifying these shocks is one thing but quantifying them is quite another. Without ignoring the obvious significance of the economic downturn, the geopolitical and supply shocks influence on current oil price trends is obvious.

What is the impact likely to be?

We list some of the many consequences below:

1. To see the price of oil rise again, growth must recover momentum and/or supply side factors must fade away. It is not unreasonable to believe that the price of crude will be $80 in 6-12 months. In periods of low prices, investment in exploration, development and production taper off, which in turn drives prices higher, all other things being equal. On top of this, the slowdown in emerging countries like China, Brazil and Russia is dragging down demand, while shale oil will probably keep the market off balance.

2. Don't confuse cause and effect. With specific regard to economic growth, it should be kept in mind that if the economic slowdown is –at least in part– responsible for the fall in oil prices, then we can’t be too excited by the idea that this same drop will boost the economies of countries already experiencing a downturn.

3. The current situation suggests that a downward revision of inflation expectations is in order, including in the eurozone. This adds to current deflation pressures and reinforces the idea that the ECB should continue its quantitative easing programmes.

4. In terms of profits, the energy sector has a weight that varies from one country to another. The graph below shows the importance of this sector in countries like Norway, but also Italy. It is certain that falling oil prices will have a marked impact in these countries. Also note Germany's absence from this graph. Germany exports heavily, but does not depend on the energy sector - in other words, two positive impacts in the current economy.

5. Countries should be divided into two groups:

Those that produce oil, some of which are highly dependent on it in terms of both the profitability of their extraction activities and their ability to balance their budgets; The graph next page presents the oil price which balances revenues and expenditures in different countries. The 50% decline in price has fragilised countries such as Ecuador, Nigeria, Russia, Bahrein, Algeria, Venezuela…

Those that consume oil and are benefiting from the current situation, on one hand due to a rise in real household income and, on the other, the fact that the impact on production cost of the products using this input is a positive one on profits and, finally, thanks to the impact on inflation. The more a country imports crude (Japan, eurozone, China, India, etc.) and/or the less it produces oil (the opposite of the United States), and the more its GDP is impacted by the energy sector (China, India, etc.), the greater these positive impacts will be.

6. For some countries, lower oil prices can be a big advantage. According to the IMF's estimates (World Economic Outlook), a $20 drop in the price of oil would, all else being equal, result in a 0.5% uptick in global GDP in 2015, followed by another jump of 0.7% if this ends up boosting confidence. Bear in mind that since mid-2013, we've seen a $40 slide. In the eurozone, the drop in the dollar price of crude can be partially offset by a drop in the euro's value against the dollar (though we should not forget the fact that some of our oil imports are invoiced in euro). In China's case, the numbers speak for themselves. China imports six million barrels per day, which means a simple $1 decline amounts to $2 billion. What is more, oil and petroleum products make up 13% of China's imports. Falling oil prices have an immediate impact on the improvement of China's current accounts.

7. For other countries, lower oil prices can spell disaster. In the case of Russia, a $20 decline could result in a 2% drop in GDP three years from now. Russia was already in an economic downturn and the fall in oil prices only exacerbated existing problems. Russia is now entering a severe recession and we predict negative GDP growth of -4.5% for 2015. However, Russia is still able to honour its commitments on its debt for 2015. Venezuela is an even more serious case, as it is on the brink of default and economic chaos: oil represents almost 40% of government revenue and 95% of exports. Bahrain, Angola and Ecuador are the other countries most vulnerable to falling oil prices.

Lower oil prices will result in lower exports and thus a deterioration in current accounts. It will also lead to a drop in the exporting governments' revenues, and make it harder to balance budgets. Let us just mention that Latin American companies that export oil generate one-third of their revenues from their oil-related activities. This figure is almost 80% of revenues for Gulf countries (57% for Qatar, and a little less than 95% for Kuwait).

Overall, oil-producing countries can be split into three groups:

• One group of "safe" countries that will be in surplus even if the price of oil stays where it is. These include Kuwait, the United Arab Emirates, Qatar and Norway, countries that have current account and budget surpluses large enough to cushion the fall of oil prices. In Norway's case, we can even count on stability of government surpluses.

• A group of "fragile" countries made extremely vulnerable by their dependence on oil and petroleum products, given their current situation. The decline in oil prices will considerably reduce their surplus, or even lead to current account and/or budget deficits. Saudi Arabia, Oman, Azerbaijan and Venezuela will face government deficits.

• A group of countries "of concern", whose financial position and oil dependency suggest that the only outcomes can be recession and/or default. These countries' financial vulnerability is taking a serious hit from the drop in oil prices.

Conclusion

As far as investors are concerned, the current environment is an argument for preferring resource-consuming countries to resource-producing countries. For the latter, this assumption also takes into account the usual solvency and economic vulnerability criteria. Canada, Norway and Kazakhstan are already looking much less risky than Russia, Bahrain,Nigeria or, even worse, than Venezuela. Watch the countries' ratings: Russia is now just one notch away from high-yield...